Stocks or Bonds: The Easy Choice

Valuations always matter.

No one knows what any market will do in the future. But with hundreds of billions of dollars pouring into bonds and 10-year Treasuries yielding 1.5%, it's worth taking a peek at what history says about the past. This quote, from The Economist, seems particularly relevant: "Investors who bought Treasury bonds at a 2% yield in 1945 earned a negative real annual return of 2.3% over the following 35 years."

Investing isn't easy, but the important parts are simple. Buy an asset when it's expensive, and future returns will likely be low. Buy cheap, and you'll probably do all right. There are ups and downs and booms and busts and lost decades throughout, but a basic appreciation of how valuation dictates the future can go a long way. It also shows why bonds produced such dreadful returns after 1945.

In the 1940s, interest rates had been falling for the better part of 20 years as the Great Depression drove knee-jerk risk aversion, and hit record lows as various policies and incentives moved to cheaply finance wartime deficits. According to Yale economist Robert Shiller, 10-year Treasuries yielded 5% in 1920, 3% by 1935, and 2% by the early 1940s. The consensus came to believe low rates were a permanent fixture. "Low Interest Rates for Long Time to Come," read one newspaper headline in 1945.

But as the saying goes, if something can't go on forever, it won't. By 1957, 10-year Treasuries yielded 4%. By 1967, 5%. They breached 8% in 1970, and zoomed to 15% by 1981 as inflation scorched the economy. Since bond prices move in the opposite direction of interest rates, this was devastating to returns. Deutsche Bank has an archive of Treasury returns in real (after inflation) terms, which tells the story:

Period

Average Annual Real Returns, 10-Year Treasuries

1940-1949

(2.5%)

1950-1959

(1.8%)

1960-1969

0.2%

1970-1979

(1.2%)

Source: Deutsche Bank Long Term Asset Return Study.

Don't underappreciate how awful this was. In real terms, $1,000 invested in 10-year Treasuries in 1940 would have been worth $584 by 1979 -- this for an investment often trumpeted as "risk-free."

No one knows if the same performance will be repeated over the coming years. Japan is a good example of extremely low interest rates sticking around for decades. But the risks are obvious. With 10-year Treasuries yielding 1.5%, there is virtually no chance of high returns over the next decade. The odds of being hammered and suffering negative real returns are, however, quite good.

How about stocks? Here, too, no one knows what the future will bring. But history has an opinion.

The same Deutsche Bank study mentioned above shows that, after inflation, stocks produced an average annual return of negative 3.4% a year from 2000 to 2009. That was the third time since 1820 that stocks underwent a decade of negative real returns. Even during the Great Depression years of 1930-1939, stocks squeezed out a positive return.

Something else that sticks out from the study's nearly 200 years of history: Stocks have never produced back-to-back decades of negative real returns. Big booms have invariably followed long slumps. Stocks logged negative real returns during the 1910s, and followed up with blistering 16% real returns in the following decade. Returns went negative again during the 1970s, then shot to nearly 12% a year in the 1980s.

That may just be a quirk of the calendar. What matters are valuations. One of the best ways to measure the overall market's value is Robert Shiller's CAPE ratio, which calculates market price divided by 10 years' average earnings, adjusted for inflation. Its current value is 21, compared with an average of 19 since the S&P 500 began in 1957. So that's a little high. But here is where stocks' long-term superior gains come into play. Since 1880, the average 10-year return after CAPE at current levels is 7.7% a year, or about 5% a year after inflation. That's nothing to write home about, but it's almost certainly better than you'll achieve in bonds these days.

Unlike bonds, there are several good, high-quality stocks with long track records that can be purchased today at prices that set you up to earn decent future returns. A few I like are Procter & Gamble(NYSE: PG), Colgate-Palmolive(NYSE: CL), and Johnson & Johnson(NYSE: JNJ). For more ideas, check out The Motley Fool's special report: "The 3 Dow Stocks Dividend Investors Need." It's free. Just click here.